ALLL / CECL Glossary

ALLL / CECL Glossary

2018-11-20T12:34:36+00:00November 20th, 2018|Blog, CECL|

Banking with all of the various acronyms can be quite confusing, not to mention when you add in terms and acronyms from the FASB. To make it easier, we’ve developed this glossary of allowance and CECL terms.

ALLL (Allowance for Loan and Lease Losses) – Originally referred to as the “reserve for bad debts,” a valuation reserve established and maintained by charges against a bank’s operating income. It is an estimate, calculated according to the incurred loss estimation model, of noncollectable amounts used to reduce the book value of loans and leases to the amount a bank can expect to collect.

ACL (Allowance for Credit Losses) – Replaces the ALLL as a reference to the allowance under CECL. ACL is a more accurate term than ALLL under CECL, as CECL applies to a broader array of financial instruments than did the incurred loss model.

Amortized Cost – The sum of the initial investment less cash collected less write-downs plus yield accreted to date.

Amortized Cost Basis – The amortized cost basis is the amount at which a financing receivable or investment is originated or acquired, adjusted for applicable accrued interest, accretion, or amortization of premium, discount, and net deferred fees or costs, collection of cash, write-offs, foreign exchange, and fair value hedge accounting adjustments.

ASU 2016-13 – The FASB update establishing a new accounting standard for estimating the allowance for credit losses (ACL). This ASU represents a significant change in the incurred loss accounting model by requiring immediate recognition of management’s estimates of current expected credit losses (CECL) throughout the lifetime of the loan.

Back-Testing- A term used in modeling to refer to testing a predictive model on historical data. Systems that quantify risk ratings in terms of default probabilities or expected loss should be back-tested. Back-tests should show that the definitions’ default probabilities and expected loss rates are largely confirmed by experience. Banks using credit models or other systems that use public rating agency default or transition information should demonstrate how their ratings are equivalent to agency ratings.

Capitalization Rate– Rate used to convert income into value. Specifically, it is the ratio between a property’s stabilized NOI and the property’s sales price. Sometimes referred to as an overall rate because it can be computed as a weighted average of component investment claims on NOI.

CECL (Current Expected Credit Loss) – An estimate of all contractual cash flows not expected to be collected from a recognized financial asset – or group of financial assets – or commitment to extend credit.

Class of Financing Receivable – A group of financing receivables determined on the basis of all of the following:

  1. Risk characteristics of the financing receivable
  2. An entity’s method for monitoring and assessing credit risk.

Cohort – An expected loss model that groups loans outstanding at the beginning of a loss accumulation period by relevant risk characteristics, measures losses accumulated on each group (cohort) over the following loss accumulation period, then averages the quarterly results over a loss cycle period for an expected loss rate for each cohort.

Collateral-Dependent Financial Asset – A collateral-dependent loan relies solely on the operation or sale of the collateral for repayment. In evaluating the overall risk associated with a loan, bank examiners consider a number of factors, including the character, overall financial condition and resources, and payment record of the borrower; the prospects for support from any financially responsible guarantors; and the nature and degree of protection provided by the cash flow and value of any underlying collateral. However, as other sources of repayment become inadequate over time, the importance of the collateral’s value necessarily increases and the loan may become collateral dependent.

Concentration Risk – Pools of exposures, whose collective performance has the potential to affect a bank negatively even if each individual transaction within a pool is soundly underwritten. When exposures in a pool are sensitive to the same economic, financial, or business development, that sensitivity, if triggered, may cause the sum of the transactions to perform as if it were a single, large exposure.

Credit Culture- A bank’s credit culture is the sum of its credit values, beliefs, and behaviors. It is what is done and how it is accomplished. The credit culture exerts a strong influence on a bank’s lending and credit risk management. Values and behaviors that are rewarded become the standards and will take precedence over written policies and procedures.

Credit Quality Indicator – A statistic about the credit quality of a financial asset

Credit Risk – The risk to current or projected financial condition and resilience arising from an obligor’s failure to meet the terms of any contract with the bank or otherwise perform as agreed. Credit risk is found in all activities in which settlement or repayment depends on counterparty, issuer, or borrower performance. Credit risk exists any time bank funds are extended, committed, invested, or otherwise exposed through actual or implied contractual agreements, whether reflected on or off the balance sheet. 

Debt Instrument – A receivable or payable that represents a contractual right to receive cash (or other consideration) or a contractual obligation to pay cash (or other consideration) on fixed or determinable dates, whether or not there is any stated provision for interest.

Debt-Service Coverage Ratio – Cash flow or NOI divided by the debt service.

Discounted Cash Flow (DCF) – A way of translating expected future cash flows into a present value. DCF is a performed at loan-level and analyzes expected cash flows adjusted for various model assumptions such as estimated prepayments; defaults; and loss severity discounted at the respective loan’s effective interest rate.

Discount Rate- A rate of return used to convert future payments or receipts into their present value.

Effective Gross Income- The expected revenue generated by a property after the application of a vacancy rate and deductions for expected credit losses.

Effective Interest Rate – The rate of return implicit in the debt instrument, that is, the contractual interest rate adjusted for any net deferred loan fees or costs, premium, or discount existing at the origination or acquisition of the debt instrument. For purchased credit-impaired financial assets, however, to decouple interest income from credit loss recognition, the premium or discount at acquisition excludes the discount embedded in the purchase price that is attributable to the acquirer’s assessment of expect credit losses at the date of acquisition.

Expected Credit Loss – An estimate of all contractual cash flows not expected to be collected from a recognized financial asset (or group of financial assets) or commitment to extend credit.

Expected Losses – A current estimate of all contractual cash flows not expected to be collected.

Fair Value – The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.

FASB’s Credit Impairment Project – An initiative by the Federal Accounting Standards Board designed to better align the accounting rules to more accurately reflect how investors view the economics of lending and its inherent credit risks and resulting in a revised standard for accounting for the allowance, Current Expected Credit Loss (CECL).

FDIC (Federal Deposit Insurance Corporation) – Is an independent agency of the federal government established in 1933 which seeks to preserve and promote public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for at least $250,000; by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect on the economy and the financial system when a bank or thrift institution fails. The FDIC insures only deposits; not securities, mutual funds, or other investment vehicles. The FDIC is also the primary federal regulator for state-chartered institutions that are not members of the Federal Reserve System.

Federal Reserve – The central bank of the United States. The Fed, as it is commonly called, was created in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. The Fed’s responsibilities are to: conduct the nation’s monetary policy; supervise and regulate banks and other important financial institution’s; maintain the stability of the financial system and contain systemic risk that may arise; and provide certain financial services to the US government, US financial and foreign institutions and play a major role in operating and overseeing the nation’s payments systems. The Federal Reserve System is composed of a central independent governmental agency and Board of Governors in Washington, D.C., and twelve regional Federal Reserve Banks in major cities throughout the United States. They do not provide banking services to individuals.

Federal Financial Institutions Examination Council (FFIEC) – The FFIEC was established in 1979 is a formal interagency body empowered to prescribe uniform principles, standards, and report forms for the federal examination of financial institutions by the Federal Reserve; FDIC; the National Credit Union Administration (NCUA); the Office of the Comptroller of the Currency (OCC); and the Consumer Financial Protection Bureau (CFPB) and to make recommendations to promote uniformity in the supervision of financial institutions. A representative state regulator was added as a voting member of the Council in October 2006.

FICO Score – FICO stands for Fair Isaac Credit Organization. A consumer has three FICO scores based on information from each national credit bureau. FICO scores are a measure of consumers’ financial responsibility, based on their credit history. 

Financial Asset – Cash, evidence of an ownership interest in an entity, or a contract that conveys to one entity a right to do either of the following:

  1. Receive cash or another financial instrument from a second entity
  2. Exchange other financial instruments on potentially favorable terms with the second entity.

A financial asset exists if and when two or more parties agree to payment terms and those payment terms are reduced to a contract. To be a financial asset, an asset must arise from a contractual agreement between two or more parties, not by an imposition of an obligation by one party on another.

Freestanding Contract – A freestanding contract is entered into either:

  1. Separate and apart from any of the entity’s other financial instruments or equity transactions
  2. In conjunction with some other transaction and is legally detachable and separately exercisable.

Gross Income – The revenue generated by a property assuming full occupancy and before the application of a vacancy rate and deductions for expected credit losses.

Hard Equity– A borrower’s tangible equity invested in a property including cash, unencumbered real estate (e.g. land), and materials for improvements.

Holding Gain or Loss – The net change in fair value of a security. The holding gain or loss does not include dividend or interest income recognized but not yet received, write-offs, or the allowance for credit losses.

Interagency Policy Statements – The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the National Credit Union Administration combine to issue guidance on the ALLL as well as other banking-related topics.

In the Process of Collection – Collection of the asset is proceeding in due course either (1) through legal action, including judgment enforcement procedures, or (2) in appropriate circumstances, through collection efforts not involving legal action which are reasonably expected to result in repayment of the debt or in its restoration to a current status in the near future.

Letters of Credit– (L/C) is a form of guarantee issued by a financial institution. An L/C rarely protects against default risk, unless it specifically can be drawn on for loan payments. An L/C issuer is typically more creditworthy than a guarantor. When an L/C that protects against default is obtained from a high-quality institution, it may effectively prevent default and losses. The issuer’s low credit risk substantially mitigates the borrower’s higher credit risk. Before a loss scenario could develop, both the borrower and the L/C issuer would have to default.

An L/C can be irrevocable, which means all parties must agree to its cancellation, or revocable, which means the L/C can be canceled or amended at the discretion of the issuer. Revocable letters do not mitigate credit risk. A standby L/C pays only when the obligor fails to perform.

Loan Classification or Credit Risk Grading System – Well-managed credit risk rating systems promote bank safety and soundness by facilitating informed decision making. Rating systems measure credit risk and differentiate individual credits and groups of credits by the risk they pose. This allows bank management and examiners to monitor changes and trends in risk levels. The process also allows bank management to manage risk to optimize returns. The foundation for any loan review system is accurate and timely loan classification or credit grading. An effective loan classification or credit grading system provides important information on the collectability of the portfolio for use in the determination of an appropriate level for the ACL.

Loan Commitment – Loan commitments are legally binding commitments to extend credit to a counterparty under certain prespecified terms and conditions. They have fixed expiration dates and may either be fixed-rate or variable-rate. Loan commitments can be either of the following:

  1. Revolving (in which the amount of the overall commitment is reestablished upon repayment of previously drawn amounts)
  2. Nonrevolving (in which the amount of the overall commitment is not reestablished upon repayment of previously drawn amounts).

Loan commitments can be distributed through syndication arrangements, in which one entity acts as a lead and an agent on behalf of other entities that will each extend credit to a single borrower. Loan commitments generally permit the lender to terminate the arrangement under the terms of covenants negotiated under the agreement.

Loan Origination Date – The time of inception of the obligation to extend credit (i.e., when the last event or prerequisite, controllable by the lender, occurs, causing the lender to become legally bound to fund an extension of credit).

Loan-to-Value or Loan-to-Value Ratio – The percentage or ratio that is derived at the time of loan origination by dividing an extension of credit by the total market value of the property(ies) securing or being improved by the extension of credit, plus the amount of any readily marketable or other acceptable non-real estate collateral. The total amount of all senior liens on or interests in such property(ies) should be included in determining the LTV ratio. When mortgage insurance or collateral is used in the calculation of the LTV ratio, and such credit enhancement is later released or replaced, the LTV ratio should be recalculated.

Loss Emergence Period (LEP) (also, Loss Discovery Period [LDP] and Loss Confirmation Period [LCP]) – The average time for a specific loan type between when loss events occur and when losses are confirmed, that is, charged off.

Loss Given Default– LGD is the financial loss a bank incurs when the borrower cannot or will not repay its debt. The amount of loss is generally affected by the quality of the underwriting and the quality of management’s supervision and administration. Underwriting standards define the structure of a loan (maturity, repayment schedule, financial reporting requirements, etc.) and establish conditions and protections that allow the bank to control the risk in the credit relationship. Such conditions and protections can include collateral and collateral margin requirements, covenants, and support required from guarantees and insurance.

Loss Migration – Calculating loss rates based on the migration of losses back through the history of a loan in order to assign the losses to risk-stratified segments. Loss migration allows for a more granular analysis of loss rates based on risk characteristics.

Market Risk Sensitivity – The degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect earnings and/or capital.

Migration Analysis – The allowance estimation methodology the purpose of which is to determine, based on the bank’s experience over a historical analysis period, the rate of loss the bank has incurred on similarly criticized or past due loans. The most basic migration analysis is fixed loss migration which analyzes a single point in time and makes determinations based on events happening to the loans that existed at that point. More sophisticated forms track the loss experience on a rolling population of loans over a period of several years. Under the new accounting standard, institutions can use the information obtained in a migration analysis to estimate expected loan losses in the loan pool. However, additional data may need to be collected by institutions to utilize this methodology.

Model – A set of ideas and numbers that describe a particular state. Relative to the allowance, any of several methods for estimating.

Model Risk Management – Supervisory Guidance issued by the Fed and OCC in 2011 and subsequently adopted by the FDIC on June 7, 2017. The guidance outlines supervisory expectations for model risk management, including: a disciplined and knowledgeable model development that is well documented and conceptually sound; controls to ensure proper implementation and use; processes to ensure correct and appropriate use; an effective validation process; and strong governance, policies, and controls.

Negative Amortization- The addition of due but unpaid interest to the principal of a mortgage loan, causing the loan balance to increase rather than decrease. Negative amortization occurs when the periodic installment payments on a loan are insufficient to repay interest due.

Nonaccrual Status- As a general rule, banks shall not accrue interest, amortize deferred net loan fees or costs, or accrete discount on any asset if: the asset is maintained on a cash basis because of deterioration in the financial condition of the borrower; payment in full of principal or interest is not expected; or principal or interest has been in default for a period of ninety days or more unless the asset is both well secured and in the process of collection (refer to the regulatory definition of well secured and in the process of collection). Banks should follow the FFIEC’s Call Report instructions when determining the accrual status for loan portfolio management.

OCC (Office of the Comptroller of the Currency) – A federal agency that charters, regulates, and supervises all national banks and federal savings associations as well as federal branches and agencies of foreign banks. The OCC is an independent bureau of the U.S. Department of the Treasury. The mission of the OCC is to ensure that national banks and federal savings associations operate in a safe and sound manner; provide fair access to financial services; treat customers fairly; and comply with applicable laws and regulations. The President, with the advice and consent of the U.S. Senate, appoints the comptroller to head the agency for a five-year term. The comptroller also is a director on the board of the Federal Deposit Insurance Corporation and NeighborWorks® America.

Operational Risk – The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events, as defined by the Basel Committee of 2004. It is an area of recognition and focus for regulators as well as bankers.

Portfolio Segment – The level at which an entity develops and documents a systematic methodology to determine its allowance for credit losses.

Prepayment– The payment of all or part of a loan before it is contractually due.

Probability of Default – The probability the loans in a certain risk-stratified segment will default expressed as a percentage. 

Probability of Default/Loss Given Default Methodology (PD/LGD) – PD is the risk that the borrower will be unable or unwilling to repay its debt in full or on time. The risk of default is derived by analyzing the obligor’s capacity to repay the debt in accordance with contractual terms. PD is generally associated with financial characteristics such as inadequate cash flow to service debt, declining revenues or operating margins, high leverage, declining or marginal liquidity, and the inability to successfully implement a business plan. In addition to these quantifiable factors, the borrower’s willingness to repay also must be evaluated.

As a method for estimating the allowance, it’s a form of migration analysis that combines the calculation of the probability of loans experiencing default events with the losses ultimately associated with the loans experiencing those defaults. The LGD component is the percentage of defaulted loan balance that is ultimately charged off. Multiplying one by the other gives the bank its loss rate, which is then applied to the loan portfolio balance to determine expected future losses.

Purchased Credit-Deteriorated (PCD) Financial Assets – New concept under CECL that replaced purchased credit-impaired (PCI) assets under existing US GAAP. This new concept requires the estimate of expected credit losses embedded in the purchase price of PCD assets to be estimated and separately recognized as an allowance as of the date of acquisition. This is accomplished by grossing up the purchase price by the amount of expected credit losses at acquisition, rather than being reported as a credit loss expense.

Q-Factors – Internal and external qualitative and environmental factors the bank has determined applicable to account for losses beyond its historical experience and quantified as part of its ALLL estimation process. The federal regulators provided a list of factors that should be considered in developing loss measurements beginning in 1993 and the list was further enhanced in subsequent policy statements.

Reinsurance Receivable – All amounts recoverable from reinsurers for paid and unpaid claims and claim settlement expenses, including estimated amounts receivable for unsettled claims, claims incurred but not reported, or policy benefits.

Remeasurement Event – A remeasurement (new basis) event is an event identified in other authoritative accounting literature, other than the measurement of an impairment under Topic 321 or credit loss under Topic 326 that requires a financial instrument to be remeasured to its fair value at the time of the event but does not require that financial instrument to be reported at fair value continually with the change in fair value recognized in earnings.

Risk Tolerance – In addition to establishing strategic objectives for the loan portfolio, senior management and the board are responsible for setting risk limits on the bank’s lending activities. Risk limits should take into consideration the bank’s historical loss experience, its ability to absorb future losses, and the bank’s desired level of return. Limits may be set in various ways, individually and in combination.

Roll Rates– Roll rates measure the movement of accounts and balances from one payment status to another (for example, percentage of accounts or dollars that were current last month rolling to 30 days past due this month).

Shadow Loss Analysis (also, Dual Loss Analysis) – A separate and different loss model, or the same model with different assumptions, used by the bank in addition to its existing model as a check on the existing model.

Stress Testing – An analysis of the impact of unfavorable economic scenarios on bank financial statements to determine whether a bank: (1) has enough capital to withstand the impact of adverse developments and (2) can continue the lending function. Stress tests are either carried out internally by banks as part of their own risk management or by supervisory authorities as part of their regulatory oversight of the banking sector. These tests are meant to detect weak spots in the banking system at an early stage, so that preventive action can be taken by the banks and regulators.

Transition Matrix Model (TMM) – Determines the probability of default (PD) of loans by tracking the historical movement of loans between loan states over a defined period of time, and establishes a probability of transition for those loan types between different loan states. The model runs those time-bracketed transition probabilities through Markov chains to determine long-term default rates. The probabilities are applied and re-applied to determine a lifetime default rate for a particular category of loans.

TDR (Troubled Debt Restructuring) – A debt restructuring is considered a TDR when the bank, for economic or legal reason related to the customer’s financial difficulties, grants a concession to the customer that it would not otherwise consider. The concession can stem from an agreement between the bank and the customer or be imposed by law or court.

Under CECL the guidance for determining whether a modification of loan terms is a TDR will remain unchanged. However, there are certain changes to the existing accounting for TDRs. Credit losses on TDRs should be calculated under the same expected credit loss methodology that is applied to other financial assets carried at amortized cost. The new accounting standard also requires that: (1) the value of concessions made is to be incorporated into the allowance estimate and (2) the pre-modification effective interest rate to be used to measure credit losses when applying the DCF method. 

Uniform Financial Institutions Rating System (UFIRS) – commonly known as CAMELS– The FFIEC adopted UFIRS in 1979 to ensure that all financial institutions are evaluated in a comprehensive and uniform manner and that supervisory attention is appropriately focused on those exhibiting financial and operational weaknesses or adverse trends.

The rating systems is commonly referred to as the CAMELS rating system because it assesses six components of a bank’s performance: capital adequacy; asset quality; management; earnings; liquidity; and sensitivity to market risk. Under this system bank examiners evaluate each component rating and assign a rating considering the bank’s size and sophistication, the nature and complexity of its activities, and its risk profile. An overall composite rating is then assigned to the institution. The rating scale is 1 – 5 with 5 being the lowest rating and in the case of the composite rating a failed institution. Each component is interrelated with one or more other components. The rating is communicated to bank management formally through the report of examination or other formal written communication. The ratings are highly confidential. Component ratings are also assigned for the specialty areas of banking including IT, trust, consumer compliance, and CRA.

Vintage – An expected loss model that tracks homogeneous loans on the basis of calendar year or quarter of origination, measures losses accumulated on each group (vintage), and applies the expected cumulative loss to the outstanding vintages.

Well-Secured– An asset is well-secured if it is secured (1) by collateral in the form of liens on or pledges of real or personal property (including securities) that have a realizable value sufficient to discharge the debt (including accrued interest) in full or (2) by the guarantee of a financially responsible party.

About the Author:

Michelle Lucci
As a senior advisor for MST Advisory Services, Michelle brings her clients more than 30 years’ experience in banking, regulation and third-party services. She holds CRCM and CAMS certifications.